Regulation by Deal

Tyler Cowen has a charactestically fine piece in yesterday's NYT, with much good sense in it. Among other things, however, he says this:

The ad hoc aspect of the bailout created a precedent for what has come to be called "regulation by deal" — now the government's modus operandi. Rather than publicizing definite standards and expectations for bailouts in advance, the Fed and the Treasury confront each particular crisis anew. Decisions are made as to whether a merger is possible, whether a consortium can be organized, what kind of loan guarantees can be offered and what kind of concessions will be extracted in return. So far, every deal — or lack thereof, in the case of Lehman Brothers — has been different.

While there are some advantages to leaving discretion in regulators' hands, this hasn't worked out very well. It has become increasingly apparent that the market doesn't know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery.

But earlier on, he says this:

With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.

So clearly a single act, albeit an exercise of administrative discretion, can create expectations and influence behavior. The problem, then, must be that that the government has not acted consistently since then. The inconsistency has created uncertainty that has frozen the credit market. But is that really true? Has the government really acted inconsistently? And, if so (with Lehman the primary exhibit), didn't most of the government actions occur after the onset of the crisis? Doesn't Tyler's argument imply that the government should have bailed out Lehman, as that would have enhanced consistency and hence predictability? Yet I think he believes the contrary.

Steven Davidoff and David Zaring coined the "regulation by deal" phrase in a recent paper that traces the government's response to the financial crisis. But what exactly does "regulation by deal" mean?

In essence, it refers to cases where the government pays someone to act in a certain way. In the typical bailout, the government gives cash or credit or some other valuable consideration in return for control rights, a right to repayment of some sort if all goes well, and a few other things (lower executive pay, no more private planes, and so forth). The usual form of regulation, by contrast, involves the passing of rules and the punishment of people who violate them.

Regulation by deal is hardly confined to the financial sector. Nearly every criminal case ends in a deal: the government offers a reduced sentence in return for a confession and cooperation. Governments make deals with witnesses when they offer them protection in return for testimony. Governments pay informers, they offer bounties, indeed they buy all sorts of thing—tanks, tractors, land, intellectual property rights, the services of contractors and employees. Most of the time regulation by deal doesn't bother us; why should it bother us now? In each case, the government pays someone for his consent to alienate something of value.

Tyler complains that the government doesn't publicize "definite standards and expectations for bailouts in advance." I'm not sure the government ever publicizes definite standards and expectations in regulation-by-deal situations. Imagine how hard it would be: "We will buy land when…"—when what? When we want it, that's when. If you want to buy things from people, you usually don't want to announce the terms in advance—that eliminates your bargaining power and opens up all sorts of avenues for strategic behavior by potential sellers. Prosecutorial discretion has frequently been criticized, and the deals that prosecutors make may not always be consistent, but no one has found a plausible alternative approach.

To be sure, the government sometimes does lay out standards for deals or purchases; indeed, we have some bailout rules in place. The FDIC system provides that if banks become insolvent, the government will pay some of their creditors up to a certain amount. This is plainly insufficient for a real financial crisis—indeed, the point of maintaining regulatory flexibility to address financial crises is that the usual regulatory tools have failed.

The question for Tyler is just what would the bailout rules that he has in mind look like? I suspect that an adequate set of rules could not be invented—and that the lesson of his column is not that regulatory discretion to address crises in the financial sector is wrong, but that a particular exercise of that discretion, the decision to bail out LTC, was wrong. What would the rules be? The institution has to be big, no? But how big? Doesn't it matter whether the financial health of other firms depend on the firm in question; if so, how many such firms and to what degree? And isn't the overall health of the economy also a relevant factor—indeed, Tyler points to the different conditions that prevailed in 1998—the budget surplus, the booming economy, the small size of the derivatives market—as a reason why the LTC bailout was a mistake. How should these factors be incorporated into a rule?

The decision to bail out a firm or industry rests on a mixture of economic, psychological, and political imponderables that can't be reduced to rules. Or such is my view. If this view is wrong, what should the bailout rules be?

Closet Libertarian (www):
Rule: Never.

Since that rule is OBE, my biggest rule would be that the bail out is temporary and one shot. Right now, I don't know when the bail outs will end, both in terms of additional firms and already receiving out money. Second, how many times can AIG come back to the trough?

When is a bailout better than bankruptcy? Maybe when short term financing will fix the problem. Thus not for auto makers nor banks with too many worthless assets.
12.29.2008 1:20pm
Joseph Heller:
'Do you dislike the fish? Do you have any hostile or aggressive emotions toward it?'
'No, not at all. In fact, I rather like the fish.'
'Then you do like the fish.'
'Oh, no. I have no feelings toward it either way.'
'But you just said you liked it. And now you say you have no feelings toward it either way. I've just caught you in a contradiction. Don't you see?'
'Yes, sir. I suppose you have caught me in a contradiction.'
Major Sanderson proudly lettered 'Contradiction' on his pad with his thick black pencil.
12.29.2008 1:57pm
Probably, no bailouts at all would be the best signal to send to the market. The problem with this "regulation by deal" is that since most risks and such are taken based on private information, while the regulation can only take place once the information becomes public. This is fine in some situations (we only cut deals with suspects after we identified them, not before we suspect them). But not in others (before the crime takes place, we can only prohibit it by proclamation, not by cutting specific deals).

Similarly, risk-taking should be regulated ex ante (when the risks are taken) and not ex pots (when the chickens come home to roost). Moreover, risk-taking should be regulated in a way that makes the risk-taker shoulder most of the consequences, and not the opposite. "Regulation by deal" after the collapse is a disaster.

In this context its important to note that a "no bailouts" policy is also a (mild) form of regulation: if everyone knows that they will personally bear the risks they are taking, they will be more cautious with their investments. Thus a useful regulation would be to increase the coupling of risks and rewards for people who gamble with other people's money. For example, requiring investment banks to inrease the ties between executive salary and fund performance would be a much better regulation than any extra conditions tacked on to a bailout given after the fund fails.
12.29.2008 2:17pm
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12.29.2008 2:46pm
Dan Simon (mail) (www):
Uh, isn't it just a bit relevant that the "bailout" of LTCM was funded entirely by LTCM's private-sector creditors, with the government acting only as a facilitator? How, exactly, would that precedent--not to mention the precedent of innumerably many troubled firms that have been similarly "bailed out" by outside private-sector purchasers since then---convince any creditors that the government would surely shove billions of dollars at them if ever they should lend recklessly enough to get themselves into deep trouble?

In fact, Cowen (who in my experience possesses the single most stunningly huge and varied collection of foolish, misguided ideas and opinions in the entire blogosphere) accidentally touches on the real problem in passing, when he mentions that "Alan Greenspan, then the Fed chairman, eased monetary policy to restart capital markets, which were starting to freeze up." That, not the "controlled bankruptcy" (as it was referred to at the time) of LTCM, was what reassured creditors that they could lend as recklessly as they pleased. The "Greenspan Put" worked in 1987, in 1998 and in 2002, and most investors seem to have believed it had the magic power to save them from any future downturn, crash or bubble, no matter how severe. And here we are...
12.30.2008 12:18am
robtastic (mail):
Spoken like a lawyer. The problem is that if the government decides to bailout "M," then N, O, P, Q, R, S, T, U, V, W, X, Y, and Z are all fine. The opposite if "M" doesn't get bailed out. Naturally, sane people are on the sideline. It is possible to know who is heading for a crisis well in advance (6 months to a year). The problem is that investors don't know (can't predict) who will be saved or let go. Case in point: A hedge fund manager at work was buyinf GM bonds because they were yielding 10%. I told him that was dumb because you can pull up Bloomberg info that says their net worth is a NEGATIVE 40 Billion. He said that "The gov won't let them fail."

Do you see the problem in inconsistent gov action? How would you like your boss to be completely inconsistent? One day you do something and he tells you top marry his daughter. The next you do the same thing and he couldn't be more angry. You would boycot doing anything more than what was specifically asked. Welcome to Investing 2009.
12.30.2008 12:22am
Curt Fischer:

Dan Simon: How, exactly, would that precedent--not to mention the precedent of innumerably many troubled firms that have been similarly "bailed out" by outside private-sector purchasers since then---convince any creditors that the government would surely shove billions of dollars at them if ever they should lend recklessly enough to get themselves into deep trouble?

This is the same question I have been asking, but as early as 2000 the GAO had identified "industry officials" who were convinced. So your question is not rhetorical, it is historical.

Here is an excerpt from the 2000 GAO report which I find so revelatory on this point.

Any type of intervention creates the potential for increased moral hazard;
however, the long-term implications of FRBNY's involvement in the
recapitalization are unknown. Although the FRBNY stressed that its
actions were dictated by the state of worldwide financial markets at that
time, its actions raised concerns among some industry officials about
moral hazard. Some industry officials said that FRBNY's involvement in
the rescue, however benign, would encourage large financial institutions to
assume more risk, in the belief that the Federal Reserve would intervene
on their behalf. According to FRBNY officials, it is unlikely LTCM's
creditors would have been able to work together to avoid the rapid
liquidation of the Fund if FRBNY officials had not intervened. Thus,
FRBNY's intervention probably affected the outcome in this case and, over
time, such actions could increase moral hazard and potentially undermine
the effectiveness of market discipline.

12.30.2008 10:13am
Crises are, almost by definition, situations that can't be foreseeable in advanced or addressable by the sorts of standard procedures that require forseeability to work.

If one wants to argue that it isn't reasonable that such things exist, one might as well argue it isn't reasonable that gravity or death by old age exists either. The universe we live in isn't always as tidy as our orderly minds might wish it to be, and sometimes we simply have to deal with its untidyness.
12.31.2008 8:05pm

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